Fed’s Stress tests for Banks – 29 Pass 1 Fail

On March 20, 2014, the Federal Reserve’s tests for banks showed that 29 out of 30 major banks met the minimum hurdle in its annual health check. Zions Bancorp fell below a 5 percent ratio for Tier-1 common equity to total assets weighted for risk, according to data released by the central bank.

So what exactly are stress tests for banks?

Stress tests are analysed on the basis of given unfavourable economic scenarios so as to check the capital strength of banks. They help in the detection of any weak spots at an early stage of banking.Banks are tested for the different type of risks like: Credit Risk, Market Risk & liquidity risk. The terminology gained a lot of importance in 2009 when the US financial system was crumbling down.

The annual stress test is one of the Federal Reserve’s most important tools to gauge the resiliency of the financial sector and to help ensure that the largest firms have strong capital positions,” Federal Reserve Governor Daniel K. Tarullo said.

How are the tests conducted?

The results are in two phases.The first of two tests for banks is Dodd-Frank Act stress test (DFAST). This measures how banks hold up under hypothetical economic conditions. DFAST tests whether banks have sufficient capital to absorb losses and support operations during adverse economic conditions (like real estate crash, unemployment increase, GDP drop, stock market crashes) while using a standardized set of capital action assumptions.

The second and last test is on on March 26, with results from the arguably more important Comprehensive Capital Analysis & Review (CCAR). Under CCAR, a bank submits its proposed capital plan for the next four quarters (dividend hikes, share buybacks), and the Fed assesses whether that bank would be able to meet required capital ratios under with the proposed action plan with shaky economic conditions. If they are in healthy financial conditions , then they can make their capital plans public.

Which banks are put to test?

The nation’s biggest banks including Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley will be put to the test.The 30 banks were also tested on how well they would withstand severe downturns in Europe and in Asian countries like China and Japan.

Most of the 30 banks tested, along with hundreds of others, received federal bailouts during the financial crisis. The banking industry has been recovering steadily since then, with overall profits rising and banks starting to lend more freely. The banks have mostly repaid the taxpayer bailouts.Together, the 30 banks accounted for about 80 percent of total banking assets in the United States, the Fed said.

Though many argue that the stress are too easy and hence raises questions on the grading system of the test. Many issues like the effects of credit freezes and contagion are not considered. Hence, if the situation that is put forth by the Federal Reserve are not too close to the real scenarios or the minimal requirement to pass is too low, then the purpose of the whole test fails. However, this also becomes important because making too many banks fail and that too big banks can raise an alarm in the market and trigger a crisis on its own. Besides, doing so can also raise big questions on one of the most popular theories on the banking system: Too Big To Fail.